4.1
The
problem todayIn addition t o the microeconomic issues of pricing, the Soviet Union today faces a huge and growing government budget deficit, money incomes t h a t are rising much more rapidly than output, worsening open and repressed inflation, and a flight from the ruble.
In a free market, rising incomes and stagnant production would result in a rise in prices - inflation - sufficient t o ration out the increased demand.
Since most retail prices are fixed in the Soviet Union, the increased demand manifests itself in barer and barer shelves in state stores and lines t h a t get longer and longer. The few goods left in the state stores are rusty tins and rotten cabbages. Free-market or black-market prices rise sharply, and the street price of hard currency diverges even more from the official rate.
Once shortages appear, the dynamics of hoarding take over as people begin t o worry about the value of their rubles and begin t o use goods as a store of value. Republics are driven t o ration basic goods like soap, meat, cigarettes, and sugar. Overvalued rubles drive out undervalued goods. In other words, the ruble is less and less convertible internally by Soviet resi- dents into Soviet goods and services.
4.2 Diagnosis
All of these are the familiar symptoms of severe repressed infiation. It is a syndrome t h a t has been seen in many countries over the twentieth century.
In understanding the issue, we separate the causes into three categories:
Ruble overhang. The "ruble overhang" signifies that households have excess spending power in currency and savings accounts. This is the result of past budget deficits.
Budget deficit. The current budget deficit adds continuously to the ru- ble overhang. The official budget deficit (expenditures less receipts) is
on the order of 10 percent of GNP. This deficit will explode in 1991 if retail prices are not raised when wholesale prices are liberalized. Because of the structure of the Soviet financial system, budget deficits are effec- tively monetized immediately; they are turned automatically into cash or savings accounts.
Hoarding. As people come t o expect price increases, there occurs an outbreak of hoarding and attempts t o flee the ruble. Particularly after the announcement of future price increases in May 1990, the shelves in state stores were cleaned out of goods. The black-market exchange rate of the ruble has fallen in 1990, another indication of price disequilibrium and widespread hoarding. More recently, there has been considerable
"dollarization", or use of foreign currencies inside the Soviet Union - a further indication of a deteriorating confidence in the ruble and of a repressed inflation.
4.3 Stabilization policies in t h e short run
As late as last summer, it might have been possible t o stabilize the economy
- bringing total demand in line with total supply by monetary and fiscal measures - prior t o taking some of the other steps. This is no longer possible;
the crisis is too severe, and stabilization now requires the support of the other measures.
T h e immediate threat is that the deterioration of economic activity and the disruption of the distribution system will get worse: fewer goods in state stores, more dollarization, greater divergence between official and black- market prices, and spiraling inflation. In response t o the breakdown of the price system, Republics and localities will turn increasingly to rationing, coupons, substitute currencies, border controls, and restrictions on move- ment of goods. The major goal of stabilization policy should be t o restrain the growth of money incomes. The primary tools for accomplishing this are through reducing the budget deficit, tightening credit, and liberalizing prices.
Given the existing budget policies and the "ruble overhang," it will be difficult t o avoid a major increase in the average price level in the period ahead. If liberalization of prices is postponed, the flight from the ruble will intensify, inflation will accelerate, and hyperinflation will become a real possibility. the best hope for avoiding this kind of total breakdown is price liberalization and a tough curb on budget and credit policies. The sooner
prices are liberalized, the smaller will be the price jump and the less will be the risk of hyperinflation.
The following steps will help stabilize the economy and prevent runaway inflation:
(1) T h e first priority is t o reduce the budget deficit. A balanced budget would effectively control the growth of incomes. If the budget is not controlled, incomes will continue to rise, and an uncontrolled price-wage- price spiral may begin.
T h e priorities for reducing the budget deficit are, in every country, subject to controversy and political debate, but we have a few concrete recommendations. The most important action in the short run would be t o liberalize prices and remove subsidies; without such a measure, the budget deficit will rise by a t least 100 billion rubles. Liberalization today is an essential step toward stabilization.
More generally, we recommend focusing on spending reductions rather than tax increases. There is clear room for reduction of subsidies t o unprofitable industries; this is in any event essential to establish mar- ket discipline. Central investments are thought t o be highly inefficient and can be cut. The allocation of hard currency might be immediately reformed, say by hard-currency auctions; this would reduce the budget deficit substantially.
(2) We believe that a substantial tightening of credit is essential t o sub- ject enterprises t o hard budget constraints. It is neither possible nor necessary in the short run to privatize the banking system in order t o have tough credit policies. In the longer run, however, creating a private banking system will help ensure that result.
In the near term, Gosbank must make enterprises financially inde- pendent by extending credit only t o firms that can repay it; this implies curbing credits t o unprofitable enterprises. In addition, the banking sys- tem must place overall credit limits on the enterprise sector, much as western central banks do today. We envision that banks will charge high interest rates t o enterprises under a regime of tight credit. In the period surrounding liberalization, real interest rates (equal to money in- terest rates less the rate of inflation) must be positive; this implies that money interest rates must be well above today's level. After inflation has stabilized, interest rates can be reduced to levels prevailing in mar- ket economies.
(3) We believe t h a t the current structure of taxes is on the whole viable for t h e immediate future. However, one major point is vitally important:
all "specific" turnover or other taxes (i.e., taxes denominated in ruble terms per unit) must be replaced with percentage or "ad valol.em7' taxes (i.e., taxes set as a percent of the product price). This step will prevent t h e erosion of real taxes as prices rise. We understand this proposal is under consideration and endorse it strongly. More generally, government expenditures should be budgeted in rubles rather than in real terms so as t o prevent t h e development of a n inflationary psychology and t o slow any inflationary spiral.
Some economists advocate a monetary reform t o solve the stabilization problem. For example, existing rubles might be exchanged for new rubles a t , say 2-to-1 or 3-to-1; other suggestions are "parallel rubles" or "gold rubles".
We believe these approaches should be avoided unless budget and monetary stability are absolutely guaranteed. If a monetary reform fails, as it surely will in the absence of strict fiscal and monetary discipline, the government will lose most of its remaining credibility. On the other hand, if monetary stability is achieved, then monetary reform is likely t o be unnecessary.
A major question is whether i t is desirable, by indexing, t o compensate various groups for price increases. We recommend minimizing the amount of automatic indexation. There is no way t o index the entire economy.
Indexation cannot produce goods; it simply redistributes real resources from one group t o another. The more the system is indexed, t h e greater is the threat of hyperinflation. Many countries have indexed their economies and have lived t o regret it; indeed, in the country with the greatest price stability, the Federal Republic Germany, wage indexation is illegal.
T h e only exception we would recommend is for transfer paymeilts t o low-income households, like pensioners, who must be protected against the hardships of a severe inflation. Indexation of wages should be altogether avoided if a t all possible.
W h a t about t h e possibility of "incomes policies", designed t o control wages and prices directly? We believe that tight fiscal and credit policies are t h e crucial ingredients for the containment of inflation. The only certain way t o check inflation is the threat of unemployment and bankruptcy t h a t prevents firms from raising prices; for this, tight budget and credit policies are essential. Incomes policies may help, but they must not be used as a substitute for fiscal and monetary discipline.